Using Life Insurance to Help Your Family Pay Estate Taxes

You’ve undoubtedly seen all of the news about the impending “fiscal cliff.” Whether you understand it or not, there will be consequences if we “fall off” at the end of 2012.

One potential change to our tax system has to do with estate taxes.

Currently, heirs do not pay federal taxes on estates smaller than $5.12 million. Above that point, they are taxed at a rate of 35%. If lawmakers don’t enact changes before December 31, 2012, estates over $1 million will be federally taxed at 55%. This could clearly become an enormous burden to many families.

While it’s possible that the government will act quickly to keep us from going off the fiscal cliff, it’s smarter for you to plan as if they won’t. One important strategy for avoiding the worry of estate taxes is through the judicious use of life insurance.

Here’s what you need to know:

Estate taxes are due nine months after death.

The IRS does give families a period of time to come up with the tax, but sometimes nine months is simply not enough. For example, if your $3.2 million estate is mostly tied up in real estate, your heirs might have trouble liquidating the property in order to pay the taxes that are due.

And if your heirs had hoped to keep the property, they still owe the tax on it, which they would have to come up with on their own. Some states have more taxes on top of this, which can further compound the problem for your heirs.

Life insurance can provide liquidity to an estate.

If, in addition to your estate, you also have a life insurance policy, the payout upon your death can provide your heirs with enough money to take care of the tax burden. Since it’s unclear exactly how big that burden will be after the end of this year, it’s advisable to sit down with your estate attorney or financial advisor to figure out how much money your heirs will need. It’s a good idea to run the worst-case scenario numbers to make certain that you will be leaving your heirs a legacy, rather than a bill.

You have life insurance options.

There are two types of life insurance: term and permanent. Term life insurance is cheaper, because it’s purchased for a set period of time, usually 10-20 years. The potential problem with term life insurance is that you could outlive the term you’ve purchased, at which point it will cost you a great deal more to purchase a new term.

Permanent life insurance (also known as whole life insurance) tends to be more expensive, but is an age-old strategy for providing your beneficiaries with cash for estate taxes.

You can avoid taxes on life insurance benefits.

It’s important to note that, depending upon how you set up your life insurance policy, your heirs may have to pay income taxes on the insurance benefit. If you name yourself as the owner of your life insurance and your child as the beneficiary, then the IRS will consider the insurance payout to your child as income. However, you can avoid that tax by making your beneficiary the owner of the policy — this will allow your heir to use that money and not have to give any up to Uncle Sam.

The Bottom Line

Whether or not the estate tax requirements change this winter, it’s smart to plan ahead for potential tax burdens after your death. Your heirs will have a lot of take care of after your death, and it is your responsibility to discuss your estate plans with a financial advisor and figure out the best way to protect them from tax burdens.

I had no idea estates were taxed that heavily over $5.12 million. That’s a LOT of tax. It’s a good idea to think of this, if that is something that you have to worry about; if the assets aren’t liquid, heirs have the responsibility of shelling out a lot of money that they may not have.

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